MUGWE: The futility of raising taxes

A petrol station attendant fuels a car in Nairobi's CBD. Photo/Monicah Mwangi

Death, taxes and
childbirth. There’s never a convenient time for any of them. This has never
rung truer than in the past week.

The hue and cry on the
increased taxes on petroleum products has reverberated across class, tribe, and
political divide. The tax increase has
raised the cost of fuel by Sh17 per litre. This was to help in reducing the
budget deficit as agreed between the government of Kenya and the International
Monetary Fund two years ago.

A budget deficit occurs
when government spending is greater than tax revenues. This leads to
accumulation of public sector debt. To correct a budget deficit, a country can
cut government spending, raise taxes, or promote economic growth. When the
deficit is unsustainable, it leads to higher interest payments and in a worst
case scenario, a loss of confidence in the government by the global money
market.

Budget deficits can be
caused by certain unanticipated events such as the repeat election we had last
year, expanding welfare programmes, tax evasions, demographic pressures of an
aging or a fast-growing population or corruption. It is forecasted that the
increased tax will earn the government an additional Sh71 billion annually. However,
this is akin to chasing a unicorn, because increasing tax to raise additional
revenue is a self-defeating strategy. Allow me to explain.

One, it stokes
avoidance. Many people devise means of circumventing to pay higher taxes. Already,
there have been reports of Kenyan motorists buying fuel in the neighbouring
countries, where it is retailing at roughly Sh22 cheaper than in Kenya. A
boycott from petroleum suppliers has also caused a widespread fuel shortage.
This results in lower or zero sales. In other scenarios, when a government
raises taxes, some of its wealthy citizens take up new citizenship in tax
havens, and enterprise owners relocate their industries to other countries with
more favourable tax regimes. An example is the proliferation of sweat shops in Asia.
Inadvertently, the net effect of avoidance is reduced tax revenue collection.

Two, it slows economic
growth. This is because it is impossible to ring-fence the costs of any tax.
For instance, in the case of public transportation, an increase of tax on
petrol or diesel shifts the economic burden to the travelers. Humans are
praxeological beings. They rank their needs according to their available means.
For example, if you had only one litre of water and had to choose between
cooking, brushing your teeth or watering your garden, you would use it on the
need you rank highest, which, in this case, is cooking. The same principle
applies when Kenyans are compelled to pay higher prices for transportation.
They may opt to walk to work, which leads to fewer clients for matatus, leading
to fewer trips thus fewer litres of fuel purchased. This leads to lower
revenues generated by the fuel entrepreneur and matatu owner, causing them to downsize.
And with job losses, people stop purchasing other goods and services. A
replication of this cycle in other sectors eventually results in a sluggish
economy and ultimately lower tax revenues.

In economics, the Laffer
Curve theory explains this relationship between tax rates and the tax revenue.
It illustrates that the more an activity is taxed, the less of it is generated.
The converse also holds true. This means that lower taxes boost economic growth
and underpins what is called the supply-side economics.

Let us conceptualise
this on a graph and plot the revenue along the x-axis, the tax rate along the
y-axis, and the point at which they intersect is zero. If the tax rate is zero
per cent, no tax revenue is generated because nobody is paying taxes. Likewise,
if the tax rate is 100 per cent, the tax revenue is still zero because nobody is
willing to work and have all their income taxed by the government leaving them
with nothing. When taxes increases from zero, it boosts government revenue
immediately. And the more the taxes go higher along the y-axis, the more the
revenue that is collected along the x-axis. However, as the tax increase
continues, the payoff in additional revenue begins diminishing as the tax base
reduces causing the curve to boomerang backwards to zero.

The Laffer curve theory
has two effects: One is arithmetic and the other is economic. Proponents of
demand-side economics only focus on the arithmetic because they view this
effect as static. It means that when tax rates are lowered, the tax revenue
will also be lowered by the amount of the decrease in the rate, and vice versa
for increasing the tax rate. So, hypothetically if the tax rate is one per
cent, the revenue may be Sh10,000, and two per cent would generate Sh20,000.
This decreases the after-tax income with every tax increment. Similarly, if the
tax rate is 0.5b per cent, the revenue generated would decrease to Shs5,000.

Demand-side economists, however,
ignore the economic effect that recognises the positive impact that lower tax
rates have on work, output and employment. When people are taxed less, it incentivizes
them to work, spend save and invest more. This increases their income and
spending on other goods and services, thus stimulating economic growth. Entrepreneurs
who are taxed less are able to re-invest into expansion of their enterprises or
invest in new enterprises thus hiring more workers, and producing more goods
and services. The net effect is a boost to economic growth, which in turn
generates a larger tax base and eventually a higher tax revenue for the
government. Conversely, raising taxes has the opposite effect.

Tax rates follow the
universal principle of demand and supply. The more costly a product or service
is, the less of it that will be demanded by the consumers and produced by
suppliers.

I, therefore, submit
that the government should dare to do different. They should lower taxes across
the board. Then sit back and watch as the economy organically flourishes. As
elucidated earlier, the government is already losing and likely to lose more,
if they do not expeditiously pivot.

Therefore, my
unsolicited advice to government is that you cannot make a fat man skinny by
tightening his belt: He has to shed the weight. Likewise, shed off government excesses
of waste and spending, and embrace austerity.

I contend that for a
nation to try to tax itself into prosperity is like a man standing in a bucket
and trying to lift himself up by the handle - Winston S Churchill